If you owe a mountain of credit card debt, is it better to file for Chapter 7 bankruptcy to get rid of it, or raid your retirement savings to pay it off? Below we discuss each of these options, and suggest a few more.
Financial advisors usually advise against touching your retirement savings if at all possible. Rarely is it a good idea to jeopardize your ability to take care of yourself in retirement for the sake of paying off debts or saving your good credit. And if you do raid your retirement savings to pay off credit card or medical debt, you will have to pay an early withdrawal tax penalty -- which makes this strategy even less desirable.
In some cases, taking a loan from your retirement plan might make sense. But you’ll have to pay it back over a certain period of time. If you have the money to do that, then it may be better to instead make payments on your debts. (To learn more, see Should I borrow from my 401(k) to pay off debt?)
Of course, everyone’s situation is different. If you already have a surplus in your retirement account or you can make up the difference in a short period of time, raiding your account might be worth considering. Always talk to a financial advisor before deciding which strategy is best for your long-term financial goals.
Bankruptcy is often an excellent way to get rid of medical debt and credit card debt. For the most part, both types of debt will be discharged in bankruptcy. (There are a few exceptions in the case of fraud, or if you purchase luxury goods too close to your filing. To learn more, see Recent Luxury Debts in Bankruptcy.)
Like anyone filing for bankruptcy, you’ll first need to figure out what happens to your property and other debts. In Chapter 7 bankruptcy, you may lose some property (although most people don’t.) In Chapter 13, you’ll need enough income to fund a repayment plan for three to five years. (To learn more, visit our Bankruptcy area.)
One drawback to bankruptcy: If you were current on debt payments, your credit will take a hit. This might matter if you plan to make a big purchase in the near future, like buying a home or car. After bankruptcy, you may have to wait to qualify for a loan, and when you do, your interest rate will likely be higher.
However, if you’ve already missed payments on your credit card debts, or have defaulted on other loans, your credit has already taken a hit. Filing for bankruptcy probably won’t have a huge impact on your already damaged credit.
If you have few assets that judgment creditors can get and little income that they can attach, you may want to do nothing. That’s because if your property is protected by exemptions, or you have no property of value, then judgment creditors cannot collect against you. Of course, defaulting on your debts will negatively affect your credit.
Before you use this strategy, make sure you won’t lose income or property you care about. Here are some things that creditors might be able to get:
Judgment creditors can attach your wages through a wage garnishment order. Federal and state law limits how much creditors can take. (To learn what is protected, visit our Wage Garnishment topic area.)
Judgment creditors could try to take the money in your bank accounts. To learn more, see Frozen Bank Accounts.
Usually, your ERISA-qualified retirement plan is protected from the collection by judgment creditors. These types of plans include 401(k) plans, deferred compensation plans, and profit sharing plans. There are a few exceptions.
However, if you have a non-ERISA retirement plan, such as an IRA, in some states it may be at risk. State laws vary as to whether those accounts are protected against judgment creditors or not, and if they are, how much of your account is safe.
To learn more about non-bankruptcy exemptions for retirement accounts, read Can Judgment Creditors Go After My Retirement Accounts.
If you have income or assets you can use to pay your debts, consider nonbankruptcy options as well. You could: